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Monday, November 01, 2010

The euro cannot live by budget discipline alone

An interesting new paper by German think tank Centrum für Europäische Politik has listed "Five hard rules for a hard Euro". It sums up some of the ideas on how to save the euro, currently floating around Germany.

Here they are:

More automatic sanctions for countries with excessive deficits.

A new sanctions regime for budget deficits should be introduced, but the paper argues that the 60% debt to GDP ratio target is arbitrary if it doesn't include how much new debt is being added every year. Interestingly, the CEP argues that the current Commission proposals necessitates Treaty change (not only Merkel's proposal for a eurozone crisis mechanism).

A 1% budget deficit should be restored as a medium-term goal, by establishing stronger preventive sanctions. This should include imposing non-interest bearing deposits on countries as a sanction, instead of interest-bearing deposits.

An insolvency procedure for member states along the lines of what Merkel has pushed for. However, the CEP argues that this only will be effective if the concept that banks are "too big to fail" is also tackled. We look forward to seeing the CEP elaborating on this point, as it's absolutely vital.

Macro-economic supervision by the European Commission would improve the functioning of the Stability Pact. However, there shouldn't be sanctions for persistent economic imbalances. Hardly surprising, the think-tank argues that EU recommendations to reduce imbalances shouldn't focus on strong export countries, as this would be to the disadvantage of Germany.

Whether all these proposals will fly is doubtful. But the paper is important, because although Merkel has won praise for getting treaty change agreed to in principle - and although we tend to favour a crisis mechanism which transfers risks away from taxpayers - some key questions remain.

Frankfurter Allgemeine Zeitung this weekend complained that Merkel has in effect already conceeded to putting in place a permanent eurozone rescue mechanism before

it is made clear how owners of state bonds would have to take a haircut in case of a rescheduling of sovereign debt.

The Telegraph's Ambrose Evans-Pritchard notes that ECB President Jean-Claude Trichet warned EU leaders on Thursday night that they didn't understand what they were unleashing. He writes that "Eurozone sovereign states must issue €915bn in new bonds next year", which might get more complicated

as investors have just been told in blunt terms to charge a hefty risk premium on any peripheral debt that expires after 2013, with great confusion over what happens even before that date.

And then there's democracy. Granting unelected bureaucracies such as the European Commission unprecedented powers over budgetary and economic policy will unavoidably weaken the powers of national Parliaments.

Ultimately, however, the proposed solutions don't tackle the core problem, which is the loss of competitiveness among eurozone countries on the periphery. (See point 5 above for the predominant German attitude to being told that this is partly Germany's fault.)

Spain and Ireland more or less respected the stability pact, but they're still in a mess - a mess in no small part caused by unsuitable interest rates in the boom-years, which were really designed to serve Germany. The only solution to these problems is a break-up of the eurozone or perpetual fiscal transfers (highlighted by so many people, including FT editor Lionel Barber a couple of days ago).

As Barber concluded, the medium term solution will be to "muddle through" but at some point the eurozone, and Germany in particular, will have to adress the eurozone's fundamental problems.